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For now, global growth would appear to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s.

The long cycle continues

The global reflation theme which unfolded over 2017 had little to do with President Trump. An end to the energy sector drag on growth in the US, coupled with solid consumer income and spending, led to a recovery there. The European economy finally responded to Draghi’s ‘whatever it takes’ stance. In China, the delayed impact of a dramatic loosening of monetary policy and increased spending on infrastructure caused a reacceleration in growth. Despite the return to globally synchronised growth, inflation and interest rates have remained low and liquidity plentiful.

The global economy appears to have achieved ‘escape velocity’ from the post Global Financial Crisis stagnation (a period of little or no economic growth). Whether this proves enduring or is merely a temporary cyclical respite remains to be seen. For now, global growth appears to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s. Notably recession indicators remain benign, lending more support to this scenario (Figure 1).

Figure 1: Recession probability signal

Source: Investec Asset Management, Bloomberg, May 2017.

Despite a sustained period of unusually low interest rates and unconventional monetary policy in the form of quantitative easing (QE), inflation in the developed world has remained persistently low. Central bank estimates of higher inflation have been repeatedly disappointed, suggesting that powerful changes in labour markets, globalisation and technology are at work. We assume some uptick in inflation rates in key economies will occur, but such changes are still likely to be muted in 2018.

Suggested investment implication:

China, moderation not collapse

Chinese growth and liquidity have become critical to the global economy. While we expect the growth rate in China itself to moderate in 2018 in response to the tighter monetary and macro prudential policies already in place, this is likely to be moderate and orderly, with rebalancing in favour of the domestic and service sector continuing.

Although China certainly has challenges, particularly in using its capital productively, it has both the will and the means to address them. Demand management has become noticeably more adept and the consolidation of power in the hands of Party Chairman Xi Jinping is likely to see an intensification of the efforts to reform the supply side of the economy via changes to state-owned enterprises. In addition, financial sector reform is likely to continue at its current pace. Local authority finance has been addressed, measures to improve the efficiency of pricing in capital markets are now in place and the focus has shifted to financial regulation more generally and the shadow banking sector in particular.

Suggested investment implication:

A positive growth outcome in China, as well as being supportive of Chinese corporate earnings growth, would be a boost for emerging markets more generally.

Commodities continue to enjoy cyclical support

Industrial metals prices were the first to signal an improving cyclical environment in early 2016 and have subsequently enjoyed a further recovery. With the cyclical backdrop set to remain positive industrial metals should remain well supported in 2018. In particular, growth in the use of electric vehicles should continue to boost copper prices.

Demand for oil should continue to enjoy cyclical support and remain firm, but supply will again depend in part on OPEC continuing to manage its own output. Higher prices are likely to be capped by the potential for shale producers in the United States to increase production flexibly.

Gold may benefit from a further bout of US dollar weakness, but we believe that there are other more attractive Defensive assets.

Suggested investment implication:

Firm commodity prices should continue to underpin the recovery of natural resource stocks.

Interest rates and monetary conditions set to become less accommodative

The rise in long-term interest rates, particularly in the United States, discounts a meaningful move higher in short-term interest rates. Despite the current cyclical upswing, considerable structural headwinds to growth remain in the form of ageing populations, high levels of debt and poor economic productivity. As such, the normal level of real interest rates (adjusted for inflation) is set to remain more modest than it has in the past. It would appear that US interest rates might only reach 2-2.5% at the cyclical peak of the economy, which is already priced in by the market. Countries like the UK, Canada and Australia in particular will quickly struggle in the face of higher interest rates because of overextended consumer and property markets.

While the US Federal Reserve Board is now in the process of actually shrinking its balance sheet (by putting its QE programme into reverse), the ‘tapering’ of QE has only just begun in the euro zone and Japan. With strong growth in both Europe and Japan, the pace of tapering will likely pick up in 2018 and Chinese monetary policy is unlikely to loosen. Central banks are also reducing support beyond monetary policy – for example, restricting the supply of credit to certain sectors. Hence overall liquidity conditions could become, if not quite restrictive, progressively less supportive.

However, given the nature of these structural issues, the lack of consensus about the impact of tapering unconventional monetary policy, and continued low core inflation rates, a gradual withdrawal of support is likely to prevail.

Suggested investment implication:

Interest rate normalisation should proceed in an orderly and gradual fashion which should be supportive of Growth assets.

Government bonds – a selective source of defensive exposure

We don’t subscribe to the bond market ‘bubble’ view, believing that the drivers which have caused developed government bond yields to decline over the last 35 years are still largely in place. However, despite disinflationary forces, less central bank bond buying, a modest pick-up in core inflation rates and possible fiscal easing are likely to cause bond yields to rise in some markets. Hence our preference for government bond markets and maturities where we believe interest rate expectations are too high, such as Canada and Australia. In our view, long-dated US Treasuries also continue to offer attractive value as a Defensive asset.

Suggested investment implication:

Investors are already pessimistic about prospects for fixed income returns, hence selective allocations to preferred markets and maturities represent an attractive source of defensive returns.

A maturing bull market for Growth assets

Many investors have remained sceptical of the current bull market cycle, missing out on returns for their clients. Beyond the various macro risks outlined above, valuation remains one of the principal concerns. By historical comparison, valuations of most Growth asset classes, and some Defensive assets as well, are now clearly expensive. Although this warrants increasing strategic caution, because high valuations point to lower returns over the longer term, valuation alone has tended to be a relatively poor medium-term indicator. Bull markets typically end just before an economic downturn and after prolonged periods of tighter monetary conditions, neither of which appear to be in place yet. In addition, market price behaviour is still risk seeking (see Figure 2). So given the high passive flows (which are not sensitive to valuation), this could yet cause a final ‘melt up’ in stock prices, as investor scepticism potentially gives way to euphoria late in the business cycle.

Suggested investment implication:

Use market strength as an opportunity to add progressively to Defensive exposure and moderate outright exposure to Growth assets.

Equity markets – recovery in cyclical sectors as yet incomplete

From the summer of 2016 there was a distinct change of leadership in equity markets. Until that point leadership was provided by defensive and interest rate sensitive sectors, reflecting enduring investor caution. Since then, growth and cyclical sensitive areas have been more highly priced, supported by strong or improving corporate earnings (see Figure 3). ‘Digital leaders’ such as Facebook and Amazon in the United States and Alibaba and Tencent in China have been in the vanguard of such a change in dynamics. We have also witnessed better performance from financials and, more recently, mining stocks. Cyclical stocks supported by strong earnings growth are likely to gain further investor attention in the year ahead.

Figure 3: Robust corporate earnings

Source: Investec Asset Management, JP Morgan, June 2017.

Better operating performance and growing investor appetite for cyclical risk has also shown up in improving performance of markets outside the United States. From a ‘bottom-up’ perspective, we believe US equities, despite appearing to be relatively expensive, have consistently offered the most attractive fundamentals. With the revival in global growth this has now changed and, in our view, equity markets outside of the United States look increasingly attractive. Asian markets, including Japan, seem to be well placed to benefit from a broader rotation out of the United States.

Finally, after a sustained period of unusually low dispersion between stocks, the current trend towards a more ‘micro’ and less ‘macro’ environment means that the current revival in active returns from fundamental stock picking looks set to continue in 2018. The broadening of an equity bull market previously dominated by the United States also provides scope to benefit from higher alpha potential from structurally less efficient markets.

Suggested investment implication:

Continue to emphasise cyclical exposure both in terms of regions and sectors. More specifically, via allocations to natural resources, Asian and emerging market equities. Favour ‘active’ versus ‘passive’ exposures to take advantage of an improving environment for stock selection ex-US equities.

Credit markets – caution warranted

Credit markets tend to be sensitive to material shifts in monetary policy. In the past, credit spreads have typically started to widen between 6 and 24 months before a more general equity market peak. The starting point is one of tight credit spreads, supported by improving corporate fundamentals and investor appetite for yield. We are confident in the former, but liquidity could prove to be more challenging and the risks are asymmetric.

Suggested investment implication:

This warrants a defensive approach and selectivity in focusing allocations in credits supported by improving fundamentals. Within the spectrum of Growth assets we continue to favour equities, as a source of income, in an environment which should continue to see solid operating performance.

Currencies – a further phase of dollar weakness?

The US dollar weakness which occurred in the first half of 2016 surprised most investors. Previously, the dollar had experienced a six-year bull cycle against the currencies of its major trading partners. A slightly shorter period than its bull cycles in the early 1980s and mid-to-late 1990s. The subsequent recovery has been muted – despite a significant covering of short positions – which suggests to us that a new down leg could unfold in 2018, confirming a medium-term bear market for the US dollar.

Despite its recovery against the euro, the US dollar remains cheap. However, in our estimation the Japanese yen is cheaper still, making it one of the most attractive Defensive exposures. If, as we believe, the Japanese economy continues to perform strongly, the Bank of Japan is likely to continue to moderate its ultra-loose monetary policy. Should market conditions turn more negative in 2018, the Japanese yen has the potential to rally dramatically.

Suggested investment implication:

Reduce US dollar exposure into rallies. Among developed market currencies, favour the Japanese yen as a cheap Defensive asset.

Emerging market debt and foreign currencies – selectivity to be rewarded with good returns

Whereas the developed world has been in a long but weak growth cycle since the catharsis of the Global Financial Crisis, with a few exceptions, the recovery of the emerging world is a much more recent affair. Generally speaking, the combination of pent up demand and continued low inflation rates should underpin the relative recovery in emerging market assets already underway. The best opportunities are likely to be found in local currencies and debt markets, provided investors avoid some of the more specific risks within the region. Selectivity will be required to extract returns from a diverse opportunity set supported by improving fundamentals.

Suggested investment implication:

Selective exposure to emerging market local currencies and debt are likely to offer attractive income and returns.

ESG – A shift in attitudes can lead to opportunities

A shift in attitudes and regulations is now prompting disruptive change in consumer and corporate behaviour, such as the take up of electric and hybrid vehicles. Slow at first, this is now proceeding more rapidly than most forecasters anticipated.

Professional investor behaviour is changing too. Over the past few years investment processes have increasingly incorporated an analysis of ESG (Environmental, Social and Governance) factors into any investment decision, alongside more traditional factors such as an assessment of valuation and company fundamentals. Increasingly, the evidence is that, if done well, this can help to improve the profile of returns.

Suggested investment implication:

It is likely that high ESG standards will increasingly be rewarded by investors. Opportunities are emerging for companies and materials, such as copper, which are beneficiaries of the shift towards environmentally and societally friendly technologies.

Important information

Collective investment schemes (CIS) are traded at ruling prices and can engage in borrowing, up to 10% of portfolio net asset value to bridge insufficient liquidity, and scrip lending. A schedule of charges, fees and advisor fees is available on request from the Manager, Investec Fund Managers SA (RF) (Pty) Ltd which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. CISs are generally medium to long-term investments and the manager gives no guarantee with respect to the capital or the return of the Fund. Performance shown is that of the Fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax and past performance is not necessarily a guide to the future. The value of participatory interests (units) may go down as well as up. Performance figures above are based on lump sum investments, using NAV to NAV figures net of fees with gross income reinvested, in South African rands. The value of participatory interests (units) may go down as well as up. Different classes of units apply to the Fund and the information presented is for the most expensive class. Fund valuations and transaction cut-off time are 16h00 SA time each business day. This portfolio may be closed in order to be managed in accordance with the mandate. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. A higher Total Expense Ratio (TER) does not necessarily imply a poor return, nor does a low TER imply a good return. Where portfolios invest in the participatory interests of foreign collective investment schemes, these may levy additional charges which are included in the relevant TER. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Fund prices are published each business day in selected media. Additional information on the Fund may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. Investec Asset Management (Pty) Ltd (Investec) is a member of the Association for Savings and Investment SA (ASISA). The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. All information provided is product related, and is not intended to address the circumstances of any Financial Service Provider’s (FSP) clients. In terms of the Financial Advisory and Intermediary Services Act, FSPs should not provide advice to investors without appropriate risk analysis and after a thorough examination of a particular client’s financial situation. Investec Asset Management (Pty) Limited is an authorised financial services provider.